Pages

Monday, May 30, 2016

My latest Macro Musings podcast is with Greg Ip, chief economics commentator for the Wall Street Journal. We covered a number of topics including how he got into macro journalism (his mom was a central banker and Nick Rowe was one of his college teachers!), his new book and its implications for macroeconomic policy, the difference between helicopter drops and QE, negative interest rates, the safe asset shortage problem, and current Fed policy.

I really enjoyed my conversation with Greg. He is a great conversationalist with a wide range of knowledge on macroeconomic issues. You will enjoy his insights.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming!

Monday, May 23, 2016

My latest Macro Musings podcast is with George Selgin, director of the Cato Institute's Center for Monetary and Financial Alternatives. We discuss in depth Selgin's call for a a Productivity Norm, a nominal income target for central banks that would result in inflation moving inversely with expected productivity growth. That is, he would have central banks stabilize aggregate demand growth but allow more price level flexibility based on technological advances. Along the way we cover the difference between benign and malign deflation and look, examine some of the historical cases of deflation, and discuss the recent productivity surge of the late 1990s and early 2000s.

It was a great conversation with George. Those listeners wanting more information on his Productivity Norm target for central banks should check out the links below.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming!

Tuesday, May 17, 2016

A few weeks ago I attended a conference on international monetary stability at Stanford's Hoover Institute. It was an interesting conference that John Taylor nicely summarizes here. I was fortunate enough to present one of the papers at the conference and got great feedback on it. The paper, coauthored with Chris Crowe, looks at two roles played by the United States in the international monetary system. First, the U.S. financial system effectively acts as a banker to world and second, the Fed has inordinate influence on global monetary conditions. We document these two roles and consider how they interact.

In this post I want to discuss the first role since it relates to an important ongoing problem previously covered here, the safe asset shortage. In my next post I will cover the second role and see how it interacts with the first role.

Safe Asset Shortage

As I have noted before, there is an ongoing safe asset shortage problem. The U.S. financial system is an important part of this story since it is a key supplier of safe assets to world. Lately, however, it has not been supplying enough safe assets to satiate demand for them. In fact, just yesterday we learned the following:

The US government paid off more debt than it issued last month in a stunning turn-around for America’s public finances, causing an acute shortage of bonds and a further downward slide in borrowing costs.

Net issuance of notes and bonds by the US Treasury plunged below zero in April as tax revenues surged, a feat last achieved for fleeting moments at the end of the global economic boom in 2008.

Normally, this would be a welcomed development but right now it may actually weaken the global economy. For since the crisis in 2008, there has been an increased demand for safe stores of value--especially U.S. treasuries--that has pushed short-term interest rates to the zero lower bound (ZLB) in many parts of the world. That development, in turn, has prevented markets from clearing. That is, the ZLB put a price floor under short-term interest rates or, alternatively, a price ceiling on the price of safe assets.

Cabellero, Fahri, and Gourinchas (2016) show that this constraint creates pressures that get cleared elsewhere, primarily in the output market. That is, real economic activity will be the adjustment mechanism once prices quit working at the ZLB. Moreover, the problem will bleed over into other countries that provide safe assets. And this is exactly what we see:

U.S. Financial System as Banker to the World

One solution to the safe asset problem is to increase the supply of safe assets. Enter the U.S. financial system. The United States, as a whole, tends to borrow short-term at low interest rates from the rest of the world while investing abroad in long term in riskier assets that earn a higher yield. By doing this, the U.S. financial system provides safe, liquid assets to the rest of the world while funding economic development abroad.

This tendency was first observed by Kindleberger (1965) and Despres et al. (1966) who saw these activities as nothing more than the maturity transformation service of a bank. They therefore called the United States the “banker to the world. Gourinchas and Rey (2007) argue that not only is the United States financial system acting as banker to the world, it increasingly acting as a venture capitalist to the world. They note that over the past few decades an increasing share of U.S. foreign investments, funded by its short-term liabilities to foreigners, became directed toward riskier assets.

The banker to the world role can be seen in Figures 1-3 which show various parts of the external balance sheet of the United States. Figure 1 shows U.S. liabilities to the rest of the world. The assets under the blue area are the liquid assets, with the darker blue being the more liquid. The gray area covers derivatives, which we assume are consider liquid assets apriori (e.g. AAA-rated CDOs). The pink and red areas are FDI and corporate equity, the riskier assets. They make up a relatively small share of U.S. liabilities to the world. Liquid assets dominate U.S. liabilities to the world.

If we now look at the asset side of the U.S. external balance sheet we see the opposite story. Here FDI and corporate equity make up a larger share. We also believe the derivative portion on this side of the balance sheet is most likely geared toward riskier assets as well. Consequently, the asset side is weighted toward risky, higher yield assets.

Figures 1 and 2 look a lot like a bank's balance sheet. To see this more clearly, the next figure shows the share of liquid assets on the liability side and the share of risky assets on the asset side. As you can see, the riskier asset share has been growing and is now over 70% of U.S. claims on the world. Meanwhile. liquid U.S. liabilities to the rest of the world sits just above 60% of outstanding liabilities.

So like a bank, the U.S. tends to fund short-term and invest long-term with the rest of the world. And like a bank, it earns a positive spread between what gets on its investments and what it pays on its liabilities:

Implications of Banker to the World Role

That the U.S. financial system plays this role has several implications. First, the U.S. economy has a greater debt capacity than would otherwise be the case. Over the past few decades, the world has become more financially integrated. However, there has not be an commensurate increase in financial deepening across the globe. Consequently, foreigners have increasingly looked to the U.S. financial system as a key producer of safe assets given its deep markets and relatively good institutions. The U.S., in other words, has a comparative advantage in exporting debt! This used to be a joke, but time has shown there is truth to it.

Second, this role also implies the growth of U.S. debt is partly endogenous to global demand for safe assets. The growth of U.S. public debt, therefore, is not just a result of Congress and the President passing budgets. It is also the result of the strong foreign demand for our treasury securities putting downward pressure on yields and making it easier for our politicians to run budget deficits. The sustained decline in yields since 2008 suggests the world wants more treasury issuance. (This speaks to the Triffin dilemma for safe assets covered here)

Third, given the absence of other reliable large-scale providers of safe assets, it is hard to see how there could be a 'run' on this banker to world in the decade ahead. To be clear, and as we show in the paper, there are other providers of safe safe assets like the United Kingdom and Germany. But they cannot produce the same scale of safe assets as the United States. This does not mean the U.S. government should become complacent in dealing with unfunded long-term liabilities, but it does mean fears of bond vigilantes are overblown. What other safe assets would investors run to in a 'bank run' on the U.S. financial system?

Recent Developments

It is useful to take a closer look at the recent trends in the U.S. supplied safe assets to world. The figures below takes the liquid assets categories from the first figure above and plots them individually in two separate figures.

The first figure below shows the publicly provided or backstopped (i.e. deposits) safe assets to the rest of the world. The key takeaway from this figure is that the demand for treasury securities, deposits, and cash grows the most. They, seemingly, are considered the safest of the safe assets.

The next figure shows the privately supply U.S. safe(ish) assets to the world. The path of short-term private safe assets like repos, commercial paper, money market mutual funds as well as longer-term private-label MBS follow an expected boom-bust path. Only the demand for corporate bonds seem to be relatively stable.

In the last figure below, we combine the above figures into one with two time series. The first series is the the safest of the safe assets: treasuries, deposits, and currency. The second series is all the other liquid assets above summed together. An interesting story emerges. During the housing boom period the demand for the super safe assets declines relative to trend while demand for the other (slightly less safe) liquid assets grows above trend. Since the crisis the opposite has happened: demand for the super safe assets has soared while the less safe liquid assets has declined. Risk aversion is high in the global economy.

Okay, so what does changing composition of global demand for U.S. safe assets mean? In my next post I will provide the answer my coauthor and I provide in our paper.

Monday, May 16, 2016

My latest Macro Musings podcast is with Ramesh Ponnuru. Ramesh is a National Review senior editor, Bloomberg view columnist, and a Visiting Fellow at the American Enterprise Institute. Ramesh has written widely on many topics from health care reform to tax policy to national security and is considered by many to be one of leading conservative intellectuals of our time. He has also written extensively on monetary policy.

Ramesh writes regularly on monetary issues for the National Review and Bloomberg View as well in other outlets like the New York Times, The Atlantic, and The New Republic. He has been a forceful advocate in the conservative movement for taking a more nuanced yet rules-based approach toward monetary policy. Among other things, he called for the Fed to adopt a Nominal GDP level target, has questioned those who claim the Fed has kept interest rates artificially low, and has pushed back against those wanting a return to the gold standard.

On a personal note, Ramesh has been a frequent coauthor of mine and was a key force behind me writing for a wider audience. So it was a real treat for me to sit down with him and do this podcast.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player. And remember to subscribe since more guest are coming!

Monday, May 9, 2016

My latest Macro Musings podcast is with Miles Kimball, professor of economies at the University of Michigan and blogger at "Confessions of a Supply-Side Liberal". Miles is a well-known advocate of breaching the zero lower bound via the adoption of negative interest rates. Moreover, he has shown how to do it without getting rid of physical cash. Miles sat down with me to discuss his ideas on this topic as well as how the macroeconomics profession has changed over the past few decades. I had a great time discussing these issues with Miles. You will enjoy the conversation too.

I would like to make several points on this controversial topic. First, if you believe in allowing markets to clear via the adjustment of prices, then you should in principle be supportive of negative interest rates. For an interest rate is just an intertemporal price--a price that clears resources across time--and sometimes a severe enough demand shock may require nominal rates to go negative for markets to clear. This is a point I have written about myself.

Second, central banks that have lowered interest rates to zero and in some cases below zero are not necessarily "artificially" depressing interest rates. It could be that a central bank is simply following the market-clearing level of interest rates--or the natural interest rate--down to lower levels as the economy weakens. This, in my view, is what most central banks have been doing in recent years. Too many observes miss this point.

Three, to underscore the point that the Fed in particular simply followed the natural interest rate down in recent years, it is important to note that the Fed is not that big of a player in the Treasury market. Some would have you believe it has bought up the entire treasury market in attempt to depress interest rates. In fact, it has about 19% of the outstanding marketable treasuries, roughly the same percent it had prior to the crisis! Most of the increase in U.S. national debt has been readily bought up by others. This speaks to the ongoing safe asset shortage problem.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player above. And remember to subscribe since more guest are coming!

Monday, May 2, 2016

My latest Macro Musings Podcast is with Cardiff Garcia, U.S. senior editor of FT Alphaville and host of the podcast FT Alphachat. After spending many years engaging with Cardiff in the econ blogosphere, it was a lot of fun having him come into studio for the podcast. Thanks Cardiff for making it happen!

In our wide-ranging conversation, we were able to talk about what it is like to be a journalist covering macroeconomics and the debates that have raged within the profession. We also got to discuss the safe asset shortage problem, QE, fiscal versus monetary policy, asymmetric inflation targets, the Eurozone crisis, secular stagnation, and more. We ended our conversation with his career advice for young budding journalists wishing to cover economic issues.

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player above. And remember to subscribe since more guest are coming!

Sunday, May 1, 2016

The Eurozone experienced a second recession in 2011-2012, just a few years after the first one in 2008-2009. This second downturn was the fatal blow that turned Europe's Great Recession into an outright depression. The standard explanation for the emergence of this second recession is the sovereign debt crisis and the increased fiscal austerity in the Eurozone periphery that occurred during this time. Is this understanding correct?

Paul Krugman says no in a new post. He points, instead, to the ECB's raising of interest rates twice in 2011 as the cause of the second recession. I agreewith Krugman. This explicit tightening of monetary policy in the Eurozone, when many of its countries had to yet to fully recover from the first recession, increased the debt burdens and gave austerity its teeth. These latter developments had an effect on the Eurozone economy, but that they were more a propagating mechanism than the initial shock. I have a new Mercatus paper coming out soon that provides extensive empirical support for this view. So I am glad to see Krugman restart the conversation on what went wrong in Europe. The Eurozone Crisis was the Lords of Finance all over again.

One question that Krugman does not address in his post is why the ECB chose to raise interest rates at this time. This, in my view, is an important question because it speaks to one of the two big shortcomings of inflation targeting that has led me to conclude its time as a monetary regime has come and gone. Unless we wrestle with inflation targeting's shortcomings, I am fairly confident we are gong to see central banks continue to repeat the ECB's mistakes in the future. To that end, I want to briefly review these shortcomings below.

Shortcoming One: Divining the Movements in Inflation

The first shortcoming of inflation targeting is that central bankers must discern in real time whether changes in inflation are caused by demand shocks or supply shocks. This is an almost impossible task that requires an herculean ability to divine developments in the economy.

Ideally, central bankers should only respond to demand shocks since they originate from changes in monetary conditions. Moreover, they push inflation and output in the same direction so it is easy for central bankers to respond to them. For example, if banks create excess money and cause inflation and real activity to grow too fast, a central banker can respond in a helpful manner by tightening monetary conditions. This will reign in both inflation and real GDP. The economy will stabilized.

Supply shocks, on the other hand, come from fundamental changes to the productive side of the economy and cannot be fixed by monetary policy. Central banks should avoid responding to temporary changes in inflation caused by these shocks. For example, if an important input to production--like oil or labor--suddenly becomes more scarce it will temporarily raise inflation. Central banks may be tempted to respond to such inflation, but doing so will only make matters worse. For to reign in such changes in inflation means to further constrict an already weakened economy. But this is exactly what happened to the ECB in 2011. It raised interest rates in response to inflation caused by rising commodity price shock (negative supply shocks) which were already weighing on weakened economy. The ECB also raised interest rates in 2008 for the same reason.

This divining problem is pervasive to all inflation targeting central banks. Supply shocks were an issue in 2002-2004 for the Fed when the productivity boom at that time (a positive supply shock) put downward pressure on prices and caused the FOMC to worry about deflation. They should not have been worrying since aggregate demand was rapidly growing. Nonetheless, the Fed kept interest rates low even as the housing and credit boom started taking off. Supply shocks were also an issue in 2008 when Fed officials, like their ECB counterparts, were concerned about rising commodity prices (a negative supply shock) and were hesitant to lower interest rates. Consequently, the Fed failed to lower interest rates fast enough and helped create the Great Recession.

Along these lines, Ben Bernanke, Mark Gertler, and Mark Watson argue the reason sudden increases in oil prices (a negative supply shock) have historically been tied to subsequent weak economic growth is not because of the oil prices themselves, but because of how monetary policy responds to those shocks. That is, the Fed typically has responded to the inflation created by supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this problem has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as noted above, is that in practice it often does not works. Responding to supply shocks in real time requires exceptional judgement and a lot of luck. Some researchers, in fact, believe inflation targeting was easier in the 1990s because central banks were luckier. There were fewer aggregate supply shocks with which central bankers had to contend. If this reading of history is correct, then it seems central bankers ran out of luck in the past decade.1

Shortcoming Two: Responding to Large Demand Shocks

The second shortcoming of inflation targeting is that it does not provide enough degrees of freedom for monetary authorities dealing with large demand shocks. This is both by design and by accident. The design part is that inflation targeting is a growth rate target, not a growth path target. By targeting the growth rate it does not make up for past mistakes. Therefore, if a large demand shortfall requires a temporary surge in inflation above 2% to restore full employment, the inflation target will prevent this from happening.

To make this clear, here is an example from my FT article. Imagine the Fed decided at the end of the Great Recession in mid-2009 to return aggregate demand (NGDP) to its pre-crisis trend path. Below is a figure from a paper of mine where I estimate what would have happened to core PCE inflation for three different recovery paths of NGDP: a two-year path, a three-year path, and a four-year path. The first figure shows the three NGDP recovery paths and the second figure shows the inflation forecasts associated with these paths.

On all paths, inflation is notably higher than both the actual inflation rate that occurred and the actual 2% target rate. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%. This never was gong to happen with the Fed or the ECB.

Now, as noted above, flexible inflation targeting could in theory accommodate such temporary deviations in inflation. However, revealed preferences over the past seven years suggest in practice it is not possible. Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone form the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.

Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy. This is why even helicopter drops will not make much difference, a point also made by Paul Krugman.

For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs. This is why we need to learn the right lessons from these past seven years and Krugman's post is a step in the right direction.

As readers of this blog will know, my solution to the above problems is NGDP level targeting. It would get past the divining problem by having central banks focus on the cause (aggregate demand shocks) and not a potentially misleading symptom (inflation) of it. As a level target, it would also be up to the task of responding to large demand shocks. To make it credible, I have proposed it be automatically back-stopped by the U.S. Treasury. Until we see a monetary regime change along these lines, we will continue to drink from the poisoned chalice of macroeconomic policy.